Employee vs. Independent Contractor: IRS Classification

Introduction and Case Overview

John, who owns his own consulting firm, is engaged to work for Make-a-Bed, a furniture manufacturer and distributor. Because he is not available as a full-time employee, it is agreed that he will work as an independent contractor. He is expected to study the business and make recommendations accordingly, arrange his own travel and meetings, dedicate approximately 20 hours per week to the project, and be paid on an hourly basis after submitting an invoice. However, John's other business ventures fail, and he ends up dedicating more of his time to Make-a-Bed. After one year passes without his having delivered any recommendations, John is replaced by another consulting agency. He then attempts to claim unemployment benefits with Make-a-Bed listed as his last employer.

In the resulting dispute, John refutes any claim that he agreed to work as an independent contractor. He testifies that he notified the Human Resource Department (HRD) whenever he would arrive early or late, that he worked regular business hours, and that the company assigned him an office. His checks were also issued from the company's payroll account. The company, on the other hand, argues that John worked extra hours for security reasons, that he was given an office only to access the business computer system, and that he was not required to give any notifications to HR. Furthermore, John did not receive any employment benefits.

IRS Framework for Worker Classification

According to the Internal Revenue Service (IRS, 2015), it is imperative for employers to establish the nature of the business relationship between themselves and any person performing a service. The IRS holds that individuals may be classified as either employees or independent contractors. In the case of employees, the employer must withhold or pay federal income, Medicare, and Social Security taxes, and must also pay unemployment tax on wages. For independent contractors, employers are not required to pay federal taxes on payments made. To determine whether an individual should be treated as an employee or an independent contractor, all information demonstrating the degree of independence and control must be considered. The IRS (2015) classifies the relevant evidence into three categories: behavioral control, financial control, and the type of relationship between the parties.

Behavioral control encompasses facts that reveal who actually controls the work. For employees, the employer provides specific direction on how work is to be carried out; for independent contractors, such detailed instructions are generally not given (IRS, 2015). Employees are also trained by the employer, whereas independent contractors rely on their own expertise.

Financial control refers to the economic aspects of the working relationship. The IRS (2015) identifies the following key indicators:

Unreimbursed expenses: Independent contractors generally bear more unreimbursed business expenses than employees.

Investment in tools and facilities: Independent contractors typically invest in their own tools and workspace, while employees generally do not.

Availability of services to the market: Independent contractors can advertise, establish their own business locations, and seek additional clients. Employees typically cannot engage in such activities on behalf of themselves.

Method of payment: Employees are usually paid wages on an hourly or regular basis, while independent contractors are often paid a flat fee based on materials and time. However, some contractors are also paid hourly.

Opportunity for profit or loss: Independent contractors can realize a profit or incur a loss from their work; employees generally cannot.

Type of relationship is assessed through the presence of a written contract, the existence of employment benefits, the anticipated duration of the relationship, and the extent to which the services performed are integral to the regular business of the company.

Applying the IRS Criteria to John's Case

In terms of behavioral control, John was given only general instructions about the nature of the engagement; he was expected to make his own recommendations after independently assessing the business. He also arranged his own travel and meetings and received no employer-provided training. These factors point toward independent contractor status.

Regarding financial control, like most independent contractors, John incurred unreimbursed travel expenses, and his consulting firm retained the ability to advertise, seek new clients, and earn profits. However, resembling an employee arrangement, he used the company's computer system and was paid on an hourly basis.

The type of relationship is difficult to determine clearly. There is no written contract, and John did not receive employment benefits — both indicators of independent contractor status. Yet he was assigned a dedicated office and paid through the regular payroll system, which could suggest an employment relationship. The evidence is thus mixed across all three categories.

References

Fishman, S. (2014). Consultant & independent contractor agreements. Berkeley, CA: NOLO.

Internal Revenue Service. (2015). Employer's supplemental tax guide (Publication 15-A). Retrieved from http://www.irs.gov/pub/irs-pdf/p15a.pdf